MacroScan - A Reticent RBI Succumbs

Though still remote and unintelligible to the ordinary citizen, the annual statement on and quarterly reviews of monetary policy by the Reserve Bank of India (RBI) receive much attention from the Finance Ministry, the financial sector and the media. This is not surprising given the increased importance of the financial sector and the crucial role of credit in the current process of growth of the Indian economy. Most often these periodic releases are long on analysis and short on new initiatives. Even when circumstances are changing rapidly, the RBI seems to err on the side of stability rather than change.

This is also true of the assessment of Macroeconomic and Monetary Developments and Review of Monetary Policy for the first quarter of 2007-08, released end-July. They reiterated concerns that have been expressed by the central bank for some time now: about the rapid and excessive inflow of foreign capital and consequent accumulation of foreign exchange reserves, the resulting overhang of liquidity in the system, the massive expansion of credit that this excess liquidity has facilitated, and the increasing direction of such credit to risky or "sensitive" sectors, especially housing and real estate.

The evidence seems to indicate that some of these trends have only gathered momentum during the first quarter of 2007-08. Thus, over the four-month period between end March and 27 July 2007, India's foreign exchange reserves rose by $26 billion as compared with $61 over the year-ending 27 July as a whole. This would have had collateral implications for the other variables of concern mentioned above. Yet, the RBI chose to be cautious in terms of new policy initiatives. It raised the cash reserve ratio requirement, or the deposits that banks have to hold at the central bank, by just 50 basis points or half a percentage point (from 6.5 to 7.0 per cent) and withdrew the ceiling of Rs.3000 crore on daily reverse repo transactions that permits banks to park funds with the central bank at a specified interest rate. While the former is expected to drain around Rs. 16,000 crore from the financial system, the latter too may limit liquidity to some extent.

However, given the current state of liquidity in the system, these are by no means large sums that would severely restrict the supply of credit relative to demand. They are expected to only have a marginal effect on interest rates paid to depositors, to make up for the larger proportion of low-interest cash reserves that the banks would have to hold. Not surprisingly, Finance Ministry mandarins and financial sector executives heaved a sigh of relief at the decision of the RBI to opt for a minor mid-course correction in policy. The RBI has merely signaled that credit must be restrained, but has done very little in pursuit of that objective.

Moreover, the RBI has suggested that even this limited effort to impound liquidity is driven primarily by the need to hold headline inflation at below 5 per cent and reduce it to the 4-4.5 per cent range in the medium term. That is, while there are references to credit quality, financial stability and global dangers in the policy statement, the response of the central bank is explained by the need to add monetary policy measures to the government's supply management efforts to curb inflation. The positive response of the financial sector to the RBI's measures is also explained by the fact that the central bank has emphasized this objective rather than focusing on its concerns with regard to excessive credit growth, poor credit quality and overexposure in stock and financial markets.

The fear that the RBI may act on these concerns explains why the quarterly monetary policy reviews and the monetary policy changes that accompany them, have been the target of special attention. Different interests fear this possibility for varying reasons. The Finance Ministry has concerns of its own making. Fiscal reform of the kind pursued by the ministry has involved a combination of tax concessions, lower tax rates and a reduction in the fiscal deficit relative to GDP. This has meant that even though rising corporate profits and top-decile incomes have helped raise the tax-GDP ratio, the ministry has found itself unable to meet the commitments which the present government has made with regard to sectors such as agriculture. The way in which the Finance Minister has dealt with the problem is to persuade the banking system to increase credit provision to that sector. Part A of recent budget speeches are full of off-budget promises to increase credit to agriculture or even for financing private educational expenditures. Not a day passes without the Finance Minister congratulating himself and his government for increasing credit provision to agriculture in recent months, even if much of that credit is not directed at farming per se. In the event, one fear that afflicts Finance Ministry mandarins is that any effort on the part of the RBI to curb credit growth, would limit their ability to use public sector banks as cash cows that partially make up for the government's inability to mobilize resources for public investment.

The second reason why the Finance Ministry and the private sector await with apprehension the RBI's monetary policy statements is that easy liquidity, low interest rates and expanding credit provide the basis for the boom in India's manufacturing sector and in the real estate and financial markets. Credit-financed purchases of automobiles and durables, investments in housing and real estate and forays into the stock market are what keep the surge in the respective markets going. If the central bank chooses to either squeeze liquidity and credit or raise interest rates, the unusual and consistently high rate of GDP growth being recorded by the economy over the eight quarters beginning with the fourth quarter of financial year 2004-05 and ending in the third quarter of 2006-07, is likely to falter.

A third factor explaining apprehensions about possible central bank intervention is the RBI's own expressions of concern about structural shifts that have been occurring in the direction of credit, in particular to the housing and real estate markets. During 2006-07, housing and real estate loans grew by 25 and 70 per cent respectively, despite having decelerated relative to their growth in the previous financial year. Further, even though direct incremental exposure of the banking system to the stock markets seems to be declining, there appears to be a sharp increase in investments in mutual fund investments, indicating a substantial degree of indirect incremental exposure to these markets.

This combination of a sharp increase in credit exposure combined with enhanced exposure to what are considered "sensitive" sectors, is indeed a cause for concern for even the central bank. The RBI, therefore, has added reason to limit credit growth and make credit more expensive. It also needs to be more proactive in dealing with rising risk and increased vulnerability in the financial sector in general and the banking sector in particular. The expectation, therefore, was that there would be an effort, beyond mere warning statements, to reverse these tendencies.

It must be noted, however, that the situation of easy liquidity is not an act of commission of the RBI. In fact, the central bank, by restricting its lending to the government and undertaking open market operations of various kinds, has been seeking to limit the growth of liquidity in the system. If yet there has been an increase in liquidity, it has been because of the surge of capital flows into the country, that have tied the hands of the RBI. During 2006-07, foreign direct investment flows rose sharply to US$ 17.7 billion from $7.7 billion in 2005-06. Cumulative net foreign institutional investor (FII) investments increased from US$ 45.3 billion at end-March 2006 to US$ 52.0 billion as at end-March 2007, or by close to $ 7 billion. And, Indian corporates have been borrowing heavily from the international market.

It is well known that to prevent an appreciation of the rupee as a result of this surge in capital inflows, the RBI has been buying dollars and adding it to its foreign exchange reserves. As a result, India's foreign exchange reserves rose from US$ 151.6 billion at the end of March 2006 US$ 199.2 billion by end-March 2007. According to the RBI, of the $46.2 billion accretion to its reserves, foreign investment accounted for $15.5 billion, NRI deposits for $3.9 billion, short term credit for $3.3 billion and external commercial borrowings for $16.1 billion. In sum, external debt of various kinds contributed to as much as $23.3 billion to reserves in 2006-07, as compared with $7.2 billion in 2006-07.
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This has two implications. Increases in the foreign assets of central bank have as their counterpart an increase in money supply, unless they are sterilized by sales of other assets. But, having done that for long, the Reserve Bank of India has little maneuverability on this front. The net result has been the increase in liquidity in the system, the consequent credit boom and the growing exposure to sensitive sectors and sub-prime borrowers. Both the volume of credit and the distribution of that credit has substantially increased risk and the threat of financial instability.

The second is that the central bank is caught in the horns of a dilemma. If it has to manage the exchange rate through its operations in the foreign exchange market it would have to lose maneuverability in the management of money supply and credit expansion. The RBI's response to this has been such that it has not been successful either in stalling rupee appreciation or in reining in credit growth.
If the RBI has to be successful it would have to move on two fronts. It would have to find ways of limiting financial capital inflow into the country, which is relatively easy given the rising share of external commercial borrowing in total inflows. It would also have to directly curb the growth of domestic credit and the use of debt for speculative purposes by impounding liquidity or drawing it out of the system and by hiking interest rates to discourage debt-financed speculative activity.

Both of these would of course squeeze liquidity and affect the debt-financed consumption and investment boom that explains in large part the recent acceleration in GDP growth. It could also correct the speculative surge being witnessed in stock and real estate markets. Not surprisingly both the Finance Ministry and the private sector are against such measures and have been exerting pressure on the central bank in myriad ways. The generalized expression of relief in the wake of the recent monetary policy review and policy announcement only proves that the RBI has indeed been limited by this pressure or has succumbed to it. That does not bode well for the future.